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70% Upside in Sensex Will Be a Reality Only If...

Apr 6, 2016

In this issue:
» FMCG companies turning back to rural markets
» Flip side of declining interest rate
» ....and more!
0.00
Tanushree Banerjee, Co-Head of Research

By now, you've probably read about Rahul Shah's prediction that the Sensex could go up as much as 70% in two to three years. If you haven't, I recommend you do so right now.

But here's the gist of it:

  • If earnings were to grow at the historical rate of 15%, and if profit margins were to rise to the last ten-year average of 13.5% from the current 12.2%, an EPS of Rs 100 can become Rs 168 by FY18, nearly a 70% jump. If the Sensex follows suit, it too can go up by as much as 70%, assuming the Sensex PE multiple remains at the current level of around 19x.

I agree with his logic that the profit margins of the largest companies, which are currently at ten-year lows, are bound to revert to the mean. In which case, the sharp surge in earnings is a given.

However, there are several moving parts to the rise in corporate earnings.

Companies grow their revenues through growth in volumes or realisations. A catalyst for the volume growth is higher demand. When companies expand capacities to accommodate new products or higher demand for existing ones, their volumes grow. Therefore, ideally, from the time the company completes its capex, it should begin to book higher revenues. As the new capacity reaches 100% utilisation, revenues will continue to grow. It is reasonable to assume that companies with pricing power will be able to increase prices at least at the average long-term inflation rate. Therefore, looking at long-term averages, revenue growth of 15% is achievable.

But what if there is overcapacity in the industry? And what if it takes a prolonged period for the new capacity to become fully utilised?

If that's the case, there is bound to be a temporary lull in revenue growth. So even if depreciation and interest costs come down (because companies are not adding more capacity), the below average topline growth could restrict growth in bottomline.

If we look at the capex spending of India's 200 largest companies from the Equitymaster Stock Market Yearbook, 50% of the incremental capex in the last ten years was incurred in FY13 and FY14. And just nine companies accounted for 50% of that.

Since those nine companies are among the largest players in the sector, their capacity utilisation will determine the sector's growth and profitability over next three years. Weak demand for their products could be a drag for not just these players; it could negatively impact volumes and realisations for the entire industry.

Share of capex in FY13 and FY14
Reliance Industries Limited 10.3%
Oil & Natural Gas Corporation Limited 9.3%
Ntpc Limited 6.1%
Indian Oil Corporation Limited 4.9%
Power Grid Corporation Of India Ltd. 4.7%
Tata Motors Limited 4.3%
Sesa Sterlite Limited 4.0%
Tata Steel Ltd. 3.8%
Hindalco Industries Limited 3.7%

Source: Equitymaster Stockmarket Yearbook

Therefore, the most important data point that I will be tracking is the capacity utilisation of companies that have recently added capacity. We will be wary of businesses in sectors that are more likely to face overcapacity in the next few years.

A 70% upside in the Sensex is a mouthwatering prospect for StockSelect. Healthy levels of capacity utilisation are, however, necessary to make the upside a reality. We are always on the lookout for the safest blue chips that could offer the best returns over the next three years. In fact, this is exactly what we articulated in our special report, Top 5 Stocks for 2020.

What will be the factors that you will follow to understand the trend in corporate earnings over next two to three years? Let us know your comments or post them on Equitymaster Club.


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3.10

The Reserve Bank of India (RBI) cut the repo rate by 1.5% since the beginning of January 2015. But what is the quantum of impact on the real rate (interest rate adjusted for consumer inflation)? Today's chart of the day shows how does India's real policy rate look when compared to that of other emerging markets.

India' s real policy rate vs Emerging Markets

While India has been able to keep its real interest rate in the positive zone since some time now, will this trend continue?

Lower commodity prices particularly declining oil prices, has been an important contributor to keep inflation at sustainable limits. However, reversal in this trend may bring real interest rates in India to near zero or even in the negative territory.

Negative real interest rates are a big dampener to an economy like India that relies heavily on savings. Negligible returns on deposits disincentives bank depositors. A sharp cut in interest rates would put the depositor in a crisis of sorts. And we may see households hoarding cash without investing or spending it. Certainly not good symptoms for an economy aiming to grow at one of the fastest rates in the world.

3.40

Fast moving consumer goods (FMCG), as the name suggests, are goods consumed on a daily basis. But are these goods available to all consumers, all the time? Certainly not. According to an article on Mint, there are around 6.4 lacs of villages where 67% of Indians reside. This class of consumers have to travel to long distances to avail them. Reportedly, FMCG companies are looking to expand their presence in the rural market through e-governance.

Under this, FMCG companies leverage the infrastructure set up by other firms. These centers are part of e-governance push to grow rural demand, and fulfill the needs of rural population. Such centers will act as point of ordering and delivering for village consumers.

This we believe will be a win-win situation for the FMCG companies. One the companies will be able to penetrate in the rural market and two the companies will be saving on the distribution costs. Companies like ITC and HUL have been taking various steps to increase their reach.

4.10

Did you hear about QE Lite? Well, Vivek Kaul claimed in his Diary that the RBI made this brand new offering in the Monetary Policy yesterday. Vivek as you know, has the skill to make the most complex regulatory nitty gritties sound amazingly simple. And his latest view comparing RBI's liquidity infusion measures to the US Fed's QE makes for a very interesting read!

4.20

You already know that on 22 April 2016, we will be celebrating our 20th anniversary. In case you wish to share your experience with Equitymaster or read what some of our valued long time subscribers have to say about us, please do so here.

This is what Xerxes V. Dastur, a reader and subscriber since last 20 years has to say about his experience with Equitymaster and its affiliates:

  • My journey with Equitymaster has been a very pleasurable experience. I believe I have been with you for most of your 20 years.
  • The reliability of the service and the best feature I like about Equitymaster is that you have stuck to your knitting and don't try and cross sell anything to your clients. There have been issues over the years but the professionalism by which issues have been resolved have always made it a pleasure to associate and use Equitymaster.
  • I congratulate the entire Equitymaster team and wish you all the best for the years to come and look forward to being there at Equitymaster's Golden Jubilee.
4.45

After opening the day on a firm note, Indian indices has lost the early gains and hovering around the dotted line. At the time of writing BSE Sensex is trading higher by 8 points. Stocks in both small cap are trading higher by 0.6% and 0.9% respectively.

4.50 Today's Investing mantra

"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Bhavita Nagrani (Research Analyst).

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